This column was originally published on RealMoney on Oct. 4 at 2:36 p.m. EDT. It's being republished as a bonus for readers.

My primary focus in my first month on RealMoney has been exchange-traded funds (ETFs), which I believe are great tools to help investors build diversified portfolios. But they are just tools and they have flaws.

Sometimes ETFs are not necessarily the best way to capture a desired effect.

A case in point would be in the materials sector over the last two months.

There are three materials ETFs: iShares Dow Jones US Basic Materials ( IYM), Materials Sector SPDR ( XLB) and Vanguard Materials VIPERs ( VAW).

Over the last two months, all three ETFs have lagged the S&P 500 as their weightings in chemical companies, including DuPont ( DD) and Dow Chemical ( DOW), have been the driver down due to higher energy prices and exposure to the hurricane-affected part of the country.

Of course, Alcoa ( AA) and International Paper ( IP) haven't helped much either.

One of the best-performing parts of the entire stock market over the last two months has been the gold-mining stocks. All three materials ETFs have about a 4% weight in Newmont Mining ( NEM), but none of them derived much benefit from the move in gold.

The point here is that the materials ETFs only capture and correlate with certain parts of the sector. Anyone trying to build a diversified portfolio with ETFs should understand these limitations. The materials sector ETFs capture chemicals more than anything else. That was a good thing for the month of July, but for August and September it wasn't. For those two months it has been stocks of gold, copper, nickel, iron ore and timber companies that outperformed, and these types of companies are not well represented in XLB, IYM or VAW.

Material ETFs

Newmont Mining

Score With Low Correlation

If the commodity bull market is for real, and I believe it is, these three ETFs won't really participate. Capturing this effect will require exposure to anything involving gold and South Africa, Latin America, Australia and copper, to name a few.

One benefit of gold and gold stocks is the low correlation to the S&P 500. There are two gold ETFs, StreetTracks Gold Trust ( GLD) and iShares Comex Gold Fund ( IAU). There are also countless gold stocks to add to a portfolio as well.

In addition to gold, timber has also historically had a very low correlation to U.S. stocks. Jack Meyer, former manager of the Harvard Endowment Fund, has preached about this for years. Timber is easily accessed through individual stocks but not ETFs. Plum Creek Timber ( PCL) and Rayonier ( RYN) are the two biggest public timber stocks.

Australia, and to a lesser extent Canada, offer another way to benefit from the resources portion of the materials sector. There are again many stocks to choose from and several ETFs: iShares Australia ( EWA), iShares Canada ( EWC) and iShares Pacific ex-Japan ( EPP), which is 65% invested in Australia.

The ETFs that capture Latin America are iShares Brazil ( EWZ) and iShares Latin America 40 ( ILF). The last ETF to mention is the iShares South Africa ( EZA).

A Strategy of Parts

Another shortcoming of the materials ETFs are dividends. All three yield between 1.5% and 1.8%, but materials is a sector I use to add some yield as well as some foreign exposure to client portfolios. For example, one name a lot of clients own is Companhia Vale Do Rio Doce ( RIO). The stock just finished a big spurt, but the company pays a healthy dividend (about 3%) and has very little, if any, correlation to the materials ETFs. There are plenty of other similar stocks to choose from in the group.

Materials comprise 2.86% of the S&P 500. Building a diversified, equal-weight position would be difficult -- how many stocks can you squeeze into 3% of a portfolio? I maintain a relatively heavy 6%-8% in the sector for most clients, due to my faith in resources, commodity-based economies and a desire to own a couple of stocks with a very low correlation to the S&P 500.

Clients have exposure to chemicals through either Dow Chemical or XLB, gold through Anglo Gold Ashanti ( AU) and timber with Plum Creek Timber. Some clients capture the emerging market, mining aspect of the sector with Rio.

This blend has worked well over the last couple of years: Whether or not it will work in the future, I offer it as a detailed example of how to build diversification within a sector using ETFs as part of the strategy, as opposed to blind reliance on the product.

P.S. from Editor-in-Chief, Dave Morrow:
It's always been my opinion that it pays to have more -- not fewer -- expert market views and analyses when you're making investing or trading decisions. That's why I recommend you take advantage of our free trial offer to RealMoney premium Web site, where you'll get in-depth commentary and money-making strategies from over 50 Wall Street pros, including Jim Cramer. Take my advice -- try it now.
At the time of publication, Nusbaum was long EWA, DOW, RIO, PCL AU and XLB, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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